The U.S. Securities and Exchange Commission (SEC) recently adopted new rules and rule amendments under the Investment Advisers Act of 1940, as amended (the Advisers Act) that will increase the regulation of private fund advisers. The rules are aimed toward three of the SEC’s stated enforcement priorities concerning investor protection and risk: (1) transparency, (2) conflicts of interest, and (3) governance mechanisms. Like most recent rules, the SEC approved them on a 3-2 vote along partisan lines.

Taken as a whole, these rules mark a significant shift in the SEC’s regulatory efforts and a corresponding increase in the compliance burdens of investment advisers. While some of the new rules will apply only to SEC registered private fund advisers, others will apply to all private fund advisers.

The SEC’s adopting release is 660 pages long and has more than 1,900 footnotes. Accordingly, the following is necessarily only a brief overview of the rules and their implications for all private fund advisers.

REGISTERED PRIVATE FUND ADVISERS

To address a perceived a lack of transparency in the practice of private fund advisers, as well as to provide a check on advisers’ potential conflicts of interest in structuring deals, the new rules impose the following requirements, among others, on registered fund advisers:

Quarterly Statement Rule

Registered private fund advisers must distribute to investors quarterly statements disclosing fund-level information regarding fund performance, private fund investing costs, fees and expenses paid by the private fund, and certain other compensation and amounts paid to the adviser.

Private Fund Audit Rule

Any private funds under advisement by a registered fund adviser must undergo a financial statement audit, in accordance with the Advisers Act “custody rule."

Adviser-Led Secondaries Rule

Registered private fund advisers must:

• •  
• obtain a fairness or valuation opinion when offering existing fund investors an adviser-led secondary transaction opportunity, and
• prepare and distribute to the investors a summary of any material business relationships the adviser has, or has had within the prior two years, with the independent opinion provider.

Books and Records Rule

The SEC has amended the Advisers Act “books and records rule” to provide the SEC with additional information for compliance enforcement purposes.

ALL PRIVATE FUND ADVISERS

In addition to the registered private fund adviser specific rules and amendments, the rules establish a number of requirements on all private fund advisers, registered or otherwise, including:

Restricted Activities Rule

All private fund advisers cannot take certain actions without first disclosing the necessary details to investors, such actions include:

• • •  
• charging or allocating to the private fund fees or expenses associated with an investigation of the adviser,
• charging or allocating to the private fund regulatory, examination, or compliance fees or expenses of such adviser,
• reducing the amount of an adviser clawback by the amount of certain taxes (unless the adviser first discloses the pre-tax and post-tax amount of the clawback),
• charging or allocating fees or expenses related to a portfolio investment on a non-pro rata basis, unless such allocation process is fair and equitable, and disclosed and explained in advance, written notice to the investors, and
• borrowing or receiving an extension of credit from a private fund client without first disclosing to, and receiving consent from, fund investors.

In addition, an adviser may not charge fees or expenses related to an investigation that results or has resulted in imposition of any sanctions for violating the Advisers Act.

Preferential Treatment Rule

All private fund advisers are prohibited from providing investors with preferential terms regarding:

• certain redemption rights, unless such redemption is required by applicable law or such right is provided to all investors without qualification, and
• certain preferential information about portfolio holdings or exposures, unless offered to all investors.

Crucially, this rule also prohibits all private fund advisers from providing preferential treatment to investors, unless certain terms are disclosed prior to an investor’s investment, and all terms are disclosed, after an investor’s investment in the fund.

OTHER REQUIREMENTS AND AMENDMENTS

The rules also require that all registered advisers, whether advising private funds or not, document in writing the annual review of their compliance policies and procedures. The Quarterly Statement, Private Fund Audit, Adviser-Led Secondaries, Restricted Activities, and Preferential Treatment rules do not apply to investment advisers with respect to securitized asset funds that they advise.

EFFECTIVE DATE AND COMPLIANCE DATES

The rules will become effective 60 days after publication in the Federal Register (the Effective Date). The compliance date for the Private Fund Audit Rule and the Quarterly Statement Rule will be 18 months after the Effective Date. For the Adviser-Led Secondaries Rule, the Preferential Treatment Rule, and the Restricted Activities Rule, the compliance dates vary depending on an adviser’s assets under management (AUM): (i) for advisers with $1.5 billion or more in private funds AUM, 12 months after the Effective Date; and for advisers with less than $1.5 billion in private funds AUM, 18 months after the Effective Date. We expect that legal actions will be filed challenging these rules but it is too early to assess their likelihood of success.

Private funds with governing agreement(s) entered into prior to the compliance date will receive legacy status under certain provisions of the Restricted Activities Rule (i.e., certain restricted activities of a private fund adviser requiring investor consent) and the prohibition aspects of the Preferential Treatment Rule if the applicable rule would require amendment of said agreement(s).

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